BIS Warns Of Risks In Annual Report

When The Future Becomes Today

The global expansion continues. But the economy still conveys a sense of uneven and unfinished adjustment. Expectations have not been met, confidence has not been restored, and huge swings in exchange rates and commodity prices in the past year hint at the need for a fundamental realignment. How far removed are we from a robust and sustainable global expansion?

When put in perspective, standard metrics indicate that macroeconomic performance is not as dire as the rhetoric may sometimes suggest (Graph I.1). True, global growth forecasts have been revised downwards once more, as they consistently have been since the Great Financial Crisis. But growth rates are not that far away from historical averages, and in a number of significant cases they are above estimates of potential. In fact, once adjusted for demographic trends, growth per working age person is even slightly above long-run trends (Chapter III). Similarly, unemployment rates have generally declined and in many cases are close to historical norms or estimates of full employment. And although inflation is still below specific targets in large advanced economies, it may be regarded as broadly in line with notions of price stability. Indeed, the downbeat expression “ongoing recovery” does not do full justice to how far the global economy has come since the crisis.

Less comforting is the context in which those economic gauges are evolving and what they might tell us about the future. One could speak of a “risky trinity”: productivity growth that is unusually low, casting a shadow over future improvements in living standards; global debt levels that are historically high, raising financial stability risks; and a room for policy maneuver that is remarkably narrow, leaving the global economy highly exposed.

As noted in last year’s Annual Report, a highly visible and much debated sign of this discomfort has been exceptionally and persistently low interest rates. And they have fallen even further since then (Graph I.2, left-hand panel). Inflation-adjusted policy rates have edged deeper below zero, continuing the longest postwar period in negative territory. Moreover, the Bank of Japan has joined the ECB, Sveriges Riksbank, Danmarks Nationalbank and the Swiss National Bank in adopting negative nominal policy rates. And at the end of May, close to $8 trillion in sovereign debt, including at long maturities, was trading at negative yields – a new record (Graph I.2, right-hand panel).

These interest rates tell us many things. They tell us that market participants look to the future with a degree of apprehension; that despite huge central bank efforts post-crisis, inflation has remained stubbornly low and output growth disappointing; and that monetary policy has been overburdened for far too long. The contrast between global growth that is not far from historical averages and interest rates that are so low is particularly stark. That contrast is also reflected in signs of fragility in financial markets and of tensions in foreign exchange markets.

Interpreting the evolution of the global economy is fraught with difficulties, but it is necessary if we are to identify possible remedies. As we have in recent Annual Reports, we offer an interpretation using a lens that focuses on financial, global and medium-term aspects. We suggest that the current predicament in no small measure reflects the failure to get to grips with hugely costly financial booms and busts (“financial cycles”). These have left long-lasting economic scars and have made robust, balanced and sustainable global expansion hard to achieve – the hallmark of uneven recovery from a balance sheet recession. Debt has been acting as a political and social substitute for income growth for far too long.

This interpretation argues for an urgent rebalancing of policy to focus more on structural measures, on financial developments and on the medium term. A key element of this rebalancing would be a keener appreciation of the cumulative impact of policies on the stocks of debt, on the allocation of resources and on the room for policy maneuver. For it is this lack of appreciation that constrains options when the future eventually becomes today. Intertemporal trade-offs are of the essence.

In this Annual Report, we update and further explore some of these themes and the tough analytical and policy challenges they raise. This chapter provides an overview of the issues. It looks first at the evolution of the global economy during the past year. It then digs deeper into some of the forces at play, putting the elements of needed macroeconomic realignments in a longer-term perspective and assessing the risks ahead. The chapter concludes with the resulting policy considerations.

The Global Economy: Salient Developments In The Past Year

By and large, the performance of the global economy in the year under review traced patterns seen in previous years, with signs of recurrent tension between macroeconomic developments and financial markets.

Global output again grew more slowly than expected, although at 3.2% in 2015 it was only slightly lower than in 2014 and not far from its 1982–2007 average (Chapter III). On balance, the projected rotation of growth from emerging market economies (EMEs) to advanced economies failed to materialize, as advanced economies did not strengthen enough to compensate for weakness in commodity-exporting EMEs. At the time of writing, consensus forecasts point to growth strengthening gradually in advanced economies and bouncing back more strongly in EMEs.

Labor markets proved more resilient. In most advanced economies, including all the largest jurisdictions, unemployment rates continued to decline. By the end of 2015, the aggregate rate was down to 6.5%, its level in 2008 before the bulk of its surge during the crisis. Even so, in some cases, unemployment remained uncomfortably high, notably in the euro area and among the young. The picture was more mixed in EMEs, with major weakness as well as some strength, but their aggregate unemployment rate edged up slightly.

This differential performance – improving employment but moderate output growth – points to weak productivity growth, the first element of the risky trinity (Graph I.3, left-hand panel). Productivity growth remained on the low side, continuing the long-term decline that had been visible at least in advanced economies and that had accelerated in those hit by the crisis.

Inflation stayed generally subdued, except in some EMEs – notably in Latin America – that experienced sharp currency depreciations (Chapter IV). In the largest advanced economies that are home to international currencies, underlying (core) inflation, while remaining below targets, moved up even as headline rates remained considerably lower. Low inflation also prevailed in much of Asia and the Pacific and in smaller advanced economies.

Once more, a critical factor in these developments was the further drop in prices for commodities, especially oil. After some signs of a pickup during the first half of last year, oil prices resumed their plunge before recovering somewhat in recent months. The generalized drop in commodity prices helps explain growth patterns across commodity exporters and importers (Chapter III). The resultant contraction in commodity exporters was only partly offset by currency depreciations against the backdrop of an appreciating US dollar. Similarly, the commodity price declines shed light on the wedge that opened up between headline and core measures and on why the most uncomfortably high inflation rates went hand in hand with weak economic activity (Chapter IV).

In the background, debt in relation to GDP continued to increase globally – the second element of the risky trinity (Graph I.3, right-hand panel). In the advanced economies worst hit by the crisis, some welcome reduction or stabilization in private sector debt tended to be offset by a further rise in the public sector. Elsewhere, a further increase in private sector debt either accompanied that in the public sector or outweighed the decline in the latter.

The financial sector’s performance was uneven (Chapter VI). In advanced economies, banks quickly adapted to the new regulatory requirements by further strengthening their capital base. Even so, non-performing loans remained very high in some euro area countries. Moreover, even where economic conditions were favorable, bank profitability was somewhat subdued. Worryingly, banks’ credit ratings have continued to decline post-crisis, and price-to-book ratios still typically languish below 1. In the past year, insurance companies did not fare much better. In EMEs, with their generally more buoyant credit conditions, the banking picture looked stronger. That said, it deteriorated where financial cycles had turned.

Financial markets alternated phases of uneasy calm and turbulence (Chapter II). The proximate cause of the turbulence was anxiety about EME growth prospects, especially China’s. A first bout of anxiety took hold in the third quarter and, after markets had regained their composure, a second appeared in early 2016 – one of the worst January sell-offs on record. This was followed by a briefer, if more intense, turbulent phase in February, when banks found themselves at the center of the storm. Triggers included disappointing earnings announcements, regulatory uncertainty concerning the treatment of contingent convertible securities (CoCos) and, above all, worries about banks’ profits linked to expectations of persistently lower interest rates following central bank moves. Thereafter, markets stabilized, notably boosting asset prices and capital flows to EMEs once more.

The alternation of calm and turbulence left a clear imprint on financial markets. By the end of the period, most equity markets were down even as price/earnings ratios remained rather high by historical standards. Credit spreads were considerably higher, especially in the energy sector and in many commodity-exporting countries. The US dollar had appreciated against most currencies. And long-term yields were plumbing new depths.

Against this backdrop, the room for macroeconomic policy maneuver narrowed further – the third element of the risky trinity. This applies most obviously to monetary policy (Chapter IV). True, the Federal Reserve began to raise the policy rate after having kept it effectively at zero for seven years. But it subsequently signaled that it would tighten more gradually than originally planned. At the same time, monetary policy eased further in other key jurisdictions through both lower interest rates and a further expansion in central bank balance sheets. The reduction in room for maneuver also applies to some extent to fiscal policy (Chapters III and V). With the fiscal stance in advanced economies turning, on balance, more neutral or supportive of economic activity in the short term, the process of long-term consolidation paused. In the meantime, fiscal positions weakened substantially in EMEs, especially commodity exporters.

The global economy: interpretation and risks

It is tempting to look at the global economy over time as a set of unrelated frames – or, in economists’ parlance, as a series of unexpected shocks that buffet it about. But a more revealing approach may be to look at it as a movie, with clearly related scenes. As the plot unfolds, the players find that what they did in the early part of the movie inevitably constrains what they can reasonably do next – sometimes in ways they had not anticipated. Again, in economists’ parlance, it is not just “shocks” but “stocks” – the underlying circumstances that have evolved – that matter. This suggested perspective may help to explain not only how we got here, but also what the future might have in store.1 It is worth briefly reviewing the key features of the movie.

Interpretation: a movie

As argued in previous Annual Reports, the movie that best describes the current predicament of the global economy probably started many years back, even before the crisis struck. And, in many respects, we may not yet have stepped out of the long shadow of the crisis.

The crisis appears to have permanently reduced the level of output. Empirical evidence increasingly indicates that growth following financial crises may recover its previous long-term trend, but the output level typically does not. So, a permanent gap opens up between the pre-crisis and post-crisis trend of the output level (Chapter V). On this basis, given the almost unprecedented breadth and depth of the recent crisis, it would be unrealistic to think that output could regain its precrisis trend. Hence the persistent disappointing outcomes and gradual ratcheting down of potential output estimates.

All this would imply that, at least for a while, the crisis reduced the growth of potential output. The persistent and otherwise puzzling slowdown in productivity growth is consistent with this. There are many candidate explanations for the mechanisms at work. But a possibly underappreciated one is the legacy of the preceding outsize financial boom (Chapter III). Recent BIS research covering more than 20 advanced economies and 40 years suggests three conclusions: financial booms can undermine productivity growth as they occur; a good chunk of the erosion typically reflects the shift of labor to sectors with lower productivity growth; and, importantly, the impact of the misallocations that occur during a boom appears to be much larger and more persistent once a crisis follows.

The corresponding effects on productivity growth can be substantial. Taking, say, a five-year boom and five post-crisis years together, the cumulative impact would amount to a loss of some 4 percentage points. Put differently, for the period 2008–13, the loss could equal about 0.5 percentage points per year for the advanced economies that saw a boom and bust. This roughly corresponds to their actual average productivity growth during the same window. The results suggest that, in addition to the well known debilitating effects of deficient aggregate demand, the impact of financial booms and busts on the supply side of the economy cannot be ignored.

In this movie, the policy response successfully stabilized the economy during the crisis, but as events unfolded, and the recovery proved weaker than expected, it was not sufficiently balanced. It paid too little attention to balance sheet repair and structural measures relative to traditional aggregate demand measures. In particular, monetary policy took the brunt of the burden even as its effectiveness
was seriously challenged. After all, an impaired financial system made it harder for easing to gain traction, over-indebted private sector agents retrenched, and monetary policy could do little to facilitate the needed rebalancing in the allocation of resources. As the authorities pushed harder on the accelerator, the room for maneuver progressively narrowed.

This had broader implications globally. For one, with domestic monetary policy channels seemingly becoming less effective, the exchange rate rose in prominence by default (Chapter IV). And resistance to unwelcome currency appreciation elsewhere helped spread exceptionally easy monetary conditions to the rest of the world, as traditional benchmarks attest (Graph I.4): easing induced easing. In addition, the exceptionally easy monetary stance in the countries with international currencies, especially the United States, directly boosted credit expansion elsewhere. From 2009 to the third quarter of 2015, US dollar-denominated credit to non-banks outside the United States increased by more than 50%, to about $9.8 trillion; and to non-banks in EMEs, it doubled to some $3.3 trillion. Global liquidity surged as financing conditions in international markets eased (Chapter III).